Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We note that Rain Industries Limited (NSE:RAIN) has debt on its balance sheet. But should shareholders worry about its use of debt?

What risk does debt carry?

Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, many companies use debt to finance their growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.

Check out our latest analysis for Rain Industries

How much debt does Rain Industries have?

You can click on the chart below for historical figures, but it shows Rain Industries had ₹84.9 billion in debt as of December 2021, up from ₹88.6 billion a year prior. However, he also had ₹13.5 billion in cash, and hence his net debt is ₹71.3 billion.

How healthy is Rain Industries’ balance sheet?

The latest balance sheet data shows that Rain Industries had liabilities of ₹29.6 billion due within a year, and liabilities of ₹93.3 billion falling due thereafter. As compensation for these obligations, he had cash of ₹13.5 billion as well as receivables valued at ₹17.9 billion due within 12 months. It therefore has liabilities totaling ₹91.4 billion more than its cash and short-term receivables, combined.

The deficiency here weighs heavily on the ₹56.5 billion business itself, like a child struggling under the weight of a huge backpack full of books, his sports gear and a trumpet . So we definitely think shareholders need to watch this one closely. After all, Rain Industries would likely need a major recapitalization if it were to pay its creditors today.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

Rain Industries has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 4.3 times. This suggests that while debt levels are significant, we will refrain from labeling them problematic. The good news is that Rain Industries has grown its EBIT smoothly by 64% over the past twelve months. Like a mother’s loving embrace of a newborn, this kind of growth builds resilience, putting the company in a stronger position to manage its debt. The balance sheet is clearly the area to focus on when analyzing debt. But it is the profits of Rain Industries that will influence the balance sheet in the future. So, if you want to know more about its earnings, it might be worth checking out this graph of its long-term trend.

But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Rain Industries has recorded free cash flow of 50% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.

Our point of view

We would go so far as to say that Rain Industries’ total passive level was disappointing. But at least it’s decent enough to increase its EBIT; it’s encouraging. Once we consider all of the above factors together, it seems to us that Rain Industries’ debt makes it a bit risky. Some people like that kind of risk, but we’re aware of the potential pitfalls, so we’d probably prefer it to take on less debt. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. For example, we found 4 warning signs for Rain Industries (1 is potentially serious!) which you should be aware of before investing here.

In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.